Chapter 5--Learning Objectives

1. Chapter 5--Learning Objectives • 1. Explain the relationship between expense recognition and revenue recognition

2. Expenses • Outflows or other using up of assets or incurrences of liabilities from delivering or producing goods, rendering services, or carrying out other activities that constitute the entity’s ongoing major or central operations

3. The matching principle • Expenses are recognized in the same period in which the benefits derived from those costs are recognized

4. Recognition of expensesis dictated by revenue recognition • The task of expense recognition is to establish associations between revenues and costs JET FUEL

5. Joint Costs • Benefit multiple accounting periods • Incurred in the production of multiple outputs

6. Chapter 5--Learning Objectives • 2. Allocate costs of long-lived tangible assets to periods benefited

7. DEPRECIATION • A process of allocating the cost of assets to the accounting periods which will benefit from their use • Allocation, not valuation • Not an attempt to approximate market value • Method must be systematic and rational

8. Units of production depreciation • Asset cost - salvage value • Total units to be produced • equals • Depreciation per unit of production • (Also used for Depletion)

9. Units of production assumptions • Asset cost $100,000 • Salvage value -0- • Projected capacity 50,000 units • Depreciation rate: • $100,000 - 0 • 50,000 units = $2.00 per unit

10. Units of production assumptions • Year 1 production 12,500 • Year 2 production 20,000 • Year 3 production 7,500 • Year 4 production 10,000

11. Units of production depreciation calculations • Year Production Depreciation • 1 12,500 units $ 25,000 • 2 20,000 units 40,000 • 3 7,500 units 15,000 • 4 10,000 units 20,000 • Totals 50,000 units $100,000

12. Accelerated Depr. assumptions • Acquisition on January 1, 20X1 • Cost $100,000 • Life estimated at 5 years • Zero salvage value

13. Sum-of-the-years’ digits (SYD) • A fraction game • For denominator, use life, count backward, add numbers • A five-year life is 5 + 4 + 3 + 2 + 1 = 15 • For numerator, start at the top and work down • First year of five-year life would be 5/15 • Apply fraction to depreciation base

14. Depreciation schedule forsum-of-the-years’ digits • Depr. Accum. Book • Year expense deprec. value • 1 33,333 33,333 66,667 • 2 26,667 60,000 40,000 • 3 20,000 80,000 20,000 • 4 13,333 93,333 6,667 • 5 6,667 100,000 -0-

15. Double-declining balance (DDB) • Think of life as a percentage • If total life is 5 years, that is 100 % • Each year will be 20 percent • Use twice the straight line rate (40% for 5 years) • In first year, apply rate to total cost (ignore salvage value at the start)

16. More double-declining balance (DDB) • In second and later years, apply rate to remaining book value • Heads up in later years--Don’t go below estimated salvage value or beyond original estimated life • DDB almost never comes out even !

17. Depreciation schedule fordouble declining balance • Depr. Accum. Book • Year expense deprec. value • 1 40,000 40,000 60,000 • 2 24,000 64,000 36,000 • 3 14,400 78,400 21,600 • 4 8,640 87,040 12,960 • 5 12,960 100,000 -0-

18. Effective Interest Depr. assumptions • Acquisition on January 1, 20X1 • Cost $100,000 • Life estimated at 5 years • Zero salvage value • Projected annual benefit $26,379 • Benefits produce a return of 10 percent compounded annually

19. Effective interest depreciation • Annual cash flow • Less: (Book value x rate of return) • Equals: Annual depreciation charge

20. Effective interest depreciation calculations • Cash Book value x Deprec. • Year flow rate of return expense • 1 26,379 (100,000 x .10) 16,379 • 2 26,379 (83,621 x .10) 18,017 • 3 26,379 (65,604 x .10) 19,819 • 4 26,379 (45,785 x .10) 21,801 • 5 26,379 (23,984 x .10) 23,984

21. Depreciation schedule foreffective interest depreciation • Depr. Accum. Book • Year expense deprec. value • 1 16,379 16,379 83,621 • 2 18,017 34,396 65,604 • 3 19,819 54,215 45,785 • 4 21,801 76,016 23,984 • 5 23,984 100,000 -0-

22. Straight line depreciation • Cost - Estimated residual value • Estimated life • $100,000 - $-0- • 5 years • $20,000 per year

23. Disposal of Assets • Calculate Depreciation for year • Reduce Assets (Cr.) • Eliminate Depreciation (Dr.) • Balance to Gain or Loss

24. Product and period costs • Product costs are production costs that become part of inventory cost and include materials, labor and factory overhead • Period costs are costs that are expensed immediately in the period incurred

25. Depreciation on the factory and the factory equipment • Is a component of factory overhead • Thus, this depreciation is a product cost

26. Chapter 5--Learning Objectives • 3. Differentiate between cost allocations for intangible assets and tangible assets

27. Research and development • Non-capital expenditures for research and development costs must be expensed in the year the cost is incurred per FASB SFAS No. 2

28. Goodwill • Internally generated goodwill is expensed as costs are incurred • In the purchase of one company by another, goodwill is the excess of the purchase price over the net fair market value of the assets • Goodwill is amortized over a period not greater than 40 years

29. Chapter 5--Learning Objectives • 4. Apply the principles of allocation of the cost-of-debt funds

30. Two possibilities for interest cost allocation • The straight-line method • (produces equal charges each period) • The effective interest rate method • (produces different charges against income, but results in a constant interest rate) • (GAAP requires the effective interest • method when the amounts are material)

31. Interest allocation assumptions • Bond face amount is $1,000,000 • Stated interest rate is 8 percent • Bonds sold January 1, 2001 • Interest paid annually on December 31 • Bonds sold for $877,068 • The effective rate is 10 percent

32. Present value calculations • Investors will receive $1,000,000 in ten years. The present value factor for 1 to be received in 10 years at 10% is .3855, so the present value of the face amount is $385,500 • Investors will also receive ten annual payments of $80,000 each on December 31. The present value factor at 10% is 6.1446, so the present value of the payments is $491,568

33. More interest calculations... • PV of face amount = $ 385,500 • PV of interest payments = 491,568 • Total present value = $ 877,068 • The total payments to be made are: • Face amount $1,000,000 • Interest payments 800,000 • Total future payments $1,800,000 • The difference is $ 922,932 • (total interest cost to be allocated)

34. The sale of the bonds will be recorded • Cash 877,068 • Discount on BP 122,932 • Bonds Payable 1,000,000 • The “Discount on Bonds Payable” account will be amortized over the life of the bond issue

35. Note that... • The total interest payments 800,000 • and the discount 122,932 • Equal the total effective • interest calculated earlier 922,932

36. Straight-line amortization • Would allocate an equal amount of the $122,932 Discount to each of the ten interest payments: • Interest Expense 92,293 • Cash 80,000 • Discount on BP 12,293

37. But • Straight-line amortization is not an acceptable procedure when the amounts are material • GAAP calls for effective interest amortization of bond premium or discount

38. In effective interest amortization • Interest expense is calculated by multiplying the effective interest rate times the “book” or “carrying” value of the liability • This is true for premium or discount situations

39. The first calculation is: • Bond carrying value 877,068 • Effective interest rate .10 • Interest expense 87,707 • The interest payment is 80,000 • The difference is 7,707 • This is the amount of amortization for the first interest payment

40. The first half of the amortization schedule is • Interest Amort. Disc. Book • Date expense amount balance value • 1-1-X1 122,932 877,068 • 12-31-X1 87,707 7,707 115,225 884,775 • 12-31-X2 88,477 8,477 106,748 893,252 • 12-31-X3 89,325 9,325 97,423 902,577 • 12-31-X4 90,258 10,258 87,165 912,835 • 12-31-X5 91,283 11,283 75,882 924,118

41. The second half of the amortization schedule is • Interest Amort. Disc. Book • Date expense amount balance value • 12-31-X5 75,882 924,118 • 12-31-X6 92,412 12,412 63,470 936,530 • 12-31-X7 93,653 13,653 49,817 950,183 • 12-31-X8 95,018 15,018 34,799 965,201 • 12-31-X9 96,520 16,520 18,279 981,721 • 12-31-Y0 98,279 18,279 -0- 1,000,000

42. Notes on effective interest amortization • Except for minor rounding errors, the effective interest method exactly amortizes the discount • The book value of the bond issue equals the present value of the payments • Procedure works the same for premium as for discount

43. Residual allocation • Differences between the book value and the actual value of assets or liabilities must be dealt with when the item is liquidated • This will result in a gain or loss in the year of liquidation • The economic developments involved are not necessarily associated with the year of liquidation

44. Residual allocation • For this reason, gains and losses on the retirement of debt are classified as “extraordinary items” on the income statement XYZ Company Income Statement

45. Opportunity costs • Not normally reflected in accounting records • But need to be considered in managing the enterprise • Allocation based accounting systems do not necessarily provide accurate performance measures for management

46. Allocating costs of labor • Labor costs include pension costs and post-retirement health benefits • These costs are difficult to estimate and often far in the future • Nevertheless, all personnel costs should be matched against the years in which the benefits of labor are recognized

47. Chapter Five Objectives • Explain the relationship between expense recognition and revenue recognition • Allocate costs of long-lived tangible assets to periods benefited • Differentiate between cost allocations for intangible assets and tangible assets • Apply the principles of allocation to the cost-of-debt funds.